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ESG INVESTING FOR PUBLIC PENSIONS:

September 2018

Does It Add Financial Value?

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TABLE OF CONTENTSExecutive Summary .............................................................................................................2

What is ESG Investing? .......................................................................................................3

What does the research say? ............................................................................................5

Illustrating the Issues with ESG ....................................................................................... 6

Case Study – New York City ............................................................................................ 6

Case Study – California ..................................................................................................... 6

Case Study – New Jersey ..................................................................................................7

Case Study – Illinois ............................................................................................................8

Conclusion .............................................................................................................................8

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EXECUTIVE SUMMARY• Environmental, Social, and Governance (ESG) investing is growing in popularity in both the private and

public sectors.

• The Institute for Pension Fund Integrity (IPFI), which focuses on fighting for fiduciary responsibility in public pension funds, believes that it is important to investigate the merits and potential scope of ESG investment, particularly when it comes to our nation’s public pension systems.

• IPFI firmly believes that the primary duty of a fiduciary is to ensure the financial stability of the funds with which they are entrusted. Fiduciaries should not be motivated by politics, ideology, or any other extrinsic force.

• On the surface, this may suggest that IPFI is against the idea of ESG investing. On the contrary, in its purest form, ESG investment can serve to add value and reduce risk in an investment portfolio. And while ESG is not always applicable, there are certainly cases in which ESG investment would be prudent.

• ESG investment measures have become increasingly politicized through institutional investors and pension funds’ growing reliance on proxy advisory firms. These advisory firms have introduced political agendas for corporate governance decision-making, leaving corporations and pension funds to operate at the whims of advisory firms with serious conflicts of interest that disregard investor value.

• In short, our position on the matter is simple: ESG investments should be made when they add value to a fund. When such investments will not improve the financial performance of the fund, or the decision to invest in them is based on political motives, they should be forgone.

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WHAT IS ESG INVESTING?ESG investing refers to investing funds according to environmental, social, and governance factors. Environmental factors include a firm’s carbon footprint, its total water consumption, and its contributions to deforestation. Social factors include a firm’s working conditions, its impact on local communities, and its contribution to local and global conflict. The third category, governance, includes corruption and overall corporate behavior. The theory behind ESG investing is that firms who act positively towards the environment, update their policies to reflect today’s societal expectations, and have strong governance practices, are more likely to produce stronger returns. Therefore, together these three categories of factors guide investors in their decision making while they choose which organizations to invest in and which to stay away from.

The ideas behind ESG investment have been around for several decades. In the 1970s, many pension funds sold off South African assets after dozens of state, counties, and cities had taken a stance against the country’s government. ESG investing involves investing an organization’s funds into endeavors deemed more “socially responsible,” because it is expected that the organization will be more profitable, and therefore have stronger stocks. Often, ESG investing takes the form of investors prioritizing organizations and firms with stronger ESG scores than investing in companies that produce controversial goods and services, such as tobacco and fossil fuels.

As ESG investing has grown over the past few decades, many have sought to develop guidelines to ensure that it is done properly to produce strong returns for the beneficiaries. For example, in 2006, the United Nations Secretary General Kofi Annan charged a group of investment professionals with developing guidelines for organizations who wanted to engage in more socially aware investment strategies. The result was the Principles for Responsible Investment (PRI). Since that time, PRI has become the globally acknowledged lead proponent of responsible investments. PRI is an independent organization that is not beholden to any political agenda, and that “encourages investors to use responsible investment to enhance returns and better manage risks.”1

As a part of its work, PRI has identified several strategies by which organizations and individuals can integrate ESG factors into their investment strategies:

1. Fundamental Strategies: Adjusting traditional financial forecasts by a firm’s impact on the relevant ESG factors

2. Quantitative Strategies: Developing models which can be used to integrate ESG factors alongside more traditional ones

3. Smart Beta Strategies: Using ESG factors as a weight when creating a portfolio to improve its overall risk

4. Passive Strategies: Using indexing based on ESG to adjust the weights on investments in a portfolio2

1 https://www.unpri.org/about-the-pri2 https://www.unpri.org/listed-equity/esg-integration-techniques-for-equity-investing/11.article

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These strategies cover a broad range of ways in which investors can use ESG to enhance their portfolios. This idea is appealing because it suggests that they can use their investments to not only increase their capital, but also make a positive impact on the world.

Because of the increase in ESG investing, 80% of companies in the S&P 500 are now producing annual corporate responsibility reports, and within the financial industry, developing a wide range of tools for investors to ensure that their ESG investments yield high returns.3 Further, with many investors looking for ways to incorporate ESG into their portfolios, several firms have taken the lead with providing guidance on the matter.

In order to help investors capitalize on the strong prospects of ESG, several organizations have established themselves as guides who can provide insight into the best way to integrate ESG investments into a portfolio. One such organization is Morningstar, which provides Sustainability Ratings for companies by comparing them to other firms in their industry “peer group.” Morningstar defines a “Portfolio Sustainability Score” as the firm’s Portfolio ESG Score” less its “Portfolio Controversy Deduction.” The Portfolio ESG Score for a firm is the weighted sum of the ESG scores of every item in its investment portfolio. Once all of the scores are calculated within a peer group, these scores are then made to fit a normal distribution with mean 50 in order to compare firms across the group. A firm’s normalized ESG score is thus defined as their placement on the distribution of scores.

A firm’s Portfolio Controversy Deduction is developed in a similar fashion. First, a controversy score is based on a firm’s relative contribution to negative impacts on environmental/social factors. Its overall score is the weighted sum of the controversy scores of each of its investments. Based on the distribution of these scores, each firm is then assigned a controversy deduction based on its relative performance. Together, the ESG score and controversy deduction create a firm’s overall sustainability score.4

A key aspect of Morningstar’s rating system is that it only allows for comparisons across industry peer groups. This is due to the relative nature of the scoring system in which firms are assigned their rating based on where they fall in the distribution of scores within their peer group. In this type of system, firms’ scores can only be compared to similar firms. For example, a small technology firm would be incomparable to a large energy firm. Therefore, the ratings would not provide strong guidance if an investor was looking to take funds out of one firm and put them into another if that other firm is in a different peer group.5 This is important as investors weigh the overall impact of their investments and estimate returns.

Understanding this aspect of the ratings system is key to its proper use and providing additional assurance that the ratings will not be used for political purposes. If the manager of an investment fund had a political agenda that involved selectively investing in only certain endeavors, he could abuse the relative rating system to justify his actions. Thus, while on the surface he may appear to be investing according to ESG criteria, he would actually be using the umbrella of ESG to hide his true political motivations.

Further, though ESG ratings can be useful when used properly, they should not be the sole metric used to make investment decisions. The Vice Fund (formerly known as the Barrier Fund) is a mutual fund that invests a significant amount of its funds into firms that profit off human ‘vices’ (i.e. tobacco, alcohol, weapons, and gambling). While such a fund would be politically unappealing to many investors, it consistently yields strong returns. Over the past five years, the fund has had a return of 10.52% and has an alpha and Sharpe Ratio of 2 and 1.008 respectively, making it a relatively high-performing, low-risk investment.6 According to Morningstar, however, unsurprisingly the Vice Fund has a low sustainability score.7 Yet even with this low score, it is still a well-performing asset, showing that while ESG is a useful tool for guiding investments, it is not the only metric that should be considered when designing a portfolio. Considering how underfunded public pensions are, this is a serious consideration that needs to be further examined.

3 https://www.dol.gov/asp/evaluation/completed-studies/ESG-Investment-Tools-Review-of-the-Current-Field.pdf4 https://www.morningstar.com/content/dam/marketing/shared/Company/Trends/Sustainability/Detail/‌Documents/Morningstar-Sustainability-

Rating-Methodology-0916.pdf5 https://www.forbes.com/sites/investor/2018/06/14/what-you-need-to-know-about-fund-sustainability-ratings/#43441d486032‌6 https://money.usnews.com/funds/mutual-funds/large-blend/usa-mutuals-vice-fund/vicex7 https://www.morningstar.com/funds/xnas/vicex/quote.html‌

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WHAT DOES THE RESEARCH SAY?The research on the impact of ESG investing is still developing and seems to suggest a differing applicability between the public and private sectors. On the one hand, the research into ESG in the private sector has yielded some very promising results. For example, one study published in the Journal of Applied Corporate Finance found that companies that have integrated ESG metrics into their investment strategies have, on average, seen higher returns and lower risks.8 Another study from The Quarterly Review of Economics and Finance suggests that for firms located in the United States and the Asia-Pacific region, investing in firms with high ESG scores yields returns at the same level as investing in firms with low scores.9 However, while ESG investing appears to have a useful tool for the private sector, the research regarding public sector ESG investment is much more mixed.

In 2016, the Center for Retirement Research (CRR) at Boston College conducted a study that looked at the effects that ESG investment has had on the nation’s public pension plans. In the study, the authors explain how every additional restriction that is placed on pension fund investment lowers the system’s ability to diversify its portfolio sufficiently. Thus, when they compared the performance of funds in states with and without ESG restrictions, the results showed that the rate of return on the plans engaged in ESG investing tended to be lower by almost 40 basis points.10 They found that the average net returns on mid-to-large sized equities were 60-70 basis points lower in ESG mutual funds when compared to Vanguard mutual funds.11

While these results are enlightening in and of themselves, it is important to try and understand why public pension systems may have such different experiences with ESG investments. The CRR article and several other studies examined the discrepancy closer and did just that. These studies have cited several reasons as to why public pension plans may not be well suited for ESG investing.

Principal-Agent Problem: The Principal-Agent problem is an age-old idea from political economics. The premise is that a problem arises when the party in charge of making decisions (the “agent”) does not have the proper incentives to focus solely on the goals of the owner of the endeavor (the “principal”). Instead, the agent often seeks to fulfill their own goals which may be misaligned with those of the principal.12 This problem is particularly relevant to public pensions as the individuals who will ultimately pay the costs for low returns (i.e. pensioners and taxpayers) are not the ones empowered to make decisions regarding the fund’s management.13

Political Heterogeneity of Beneficiaries: Even if some of the beneficiaries are willing to accept lower returns for the sake of some political agenda, the heterogeneity of plan participants practically assures that not everyone will feel this way.14

Lack of Data: There is currently a lack of resources and data to guide pension fund managers in ESG investment and to ensure they are making financially responsible decisions.15

Thus, while there are times when ESG investing may be prudent for public pensions, it is not yet a universally applicable investment strategy.

8 https://onlinelibrary.wiley.com/doi/pdf/10.1111/jacf.121699 https://www.sciencedirect.com/science/article/pii/S106297691500077010 http://crr.bc.edu/wp-content/uploads/2016/11/slp_53-1.pdf11 Ibid.12 https://www.investopedia.com/terms/p/principal-agent-problem.asp13 https://www.oecd.org/finance/private-pensions/35802785.pdf14 Ibid.15 https://www.forbes.com/sites/tedknutson/2018/05/22/esg-investing-roadblocks-by-retirement-plans-should-be-removed-urges-congressional-

report/#57865dc4517a

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ILLUSTRATING THE ISSUES WITH ESGAs stated previously, ESG has the potential to be used as a valuable tool for investors to increase returns and lower risk. Its promising performance in the private sector all but assures that it will continue to play a large role in the investment world. However, ESG presents specific problems to the public sector that makes its utility and value proposition much less clear. What follows are case studies and examples of how the problems outlined above can be seen in the actions of pension managers in the real world.

Case Study – New York City In 200316, the United States Securities and Exchange Commission (SEC) enacted a rule that required institutional investors to develop and disclose information pertaining to their proxy-voting decisions and the reasoning behind those decisions. Firms could also exercise the option to rely on the guidance of proxy advisory firms to make voting decisions, releasing the institutional investor from responsibility regarding the voting decision.

These sorts of actions are especially important to pensioners and those involved in pooled investment plans. Any time public officials with jurisdiction over pensioners’ money use their leadership positions to influence corporate decisions that adhere to their own political ideologies, they violate their fiduciary duty. Further, by weaponizing the massive holdings of public pension systems, politicians are putting the beneficiaries of those plans at risk through corporate policies that focus on politics and not profit.

One of the major violators of this principle is New York City Comptroller Scott Stringer. In 2017, Comptroller Stringer boasted about the ‘backing from independent proxy advisory firms’17 that he received in relation to a pharmaceutical company and their executive compensation. Citing proxy advisory firms as ‘independent’ was the first false narrative presented by the comptroller in his announcement, but it is not the last time the comptroller’s office has shared his preference for the power of proxy advisory firms. In 2018, Stringer’s office stated18 that “proxy access is now a market standard for long-term investors.” In a press release, Stringer’s office showed a graphic with ESG language where he referred to the progressive causes his office had championed. The issue with these initiatives, like climate risk reporting and industry specific targeting, is their lack of value added to the corporations that are forced to enact them. According to ACCA Global, only 19% of investors19 found the inclusion of ESG-measures ‘very important’ on yearly financial reports, showing that while these measures may look good for re-election campaigns, they carry minimal weight in the minds of investors caring about concrete financials of a corporation.

Relying on third party advising presents risk as proxy advisory firms are not independent entities. The advisory firm Institutional Shareholder Server (ISS), one of the two firms holding 97%20 of the combined market share in the industry, sells its services to corporations that are “trying to get in its corporate good-governance graces” as the Wall Street Journal editorial board recently assessed.21 This conflict of interest presents great risk to the companies and pension funds affected by proxy voting decisions. Proxy recommendations could guide corporate decisions in less than profitable directions under the guise of ESG proposals.

Case Study – CaliforniaIn 2000, the board of the California Public Employee Retirement System (CalPERS) voted to divest its investments from tobacco companies. This vote resulted in the plan selling off over $670 million in tobacco stocks. CalPERS defended its decision by arguing that tobacco is an unhealthy product that contributes to major health issues and lower life expectancies and that, as a government agency, it could not take part in the funding of such a product.

16 https://www.sec.gov/news/press/2003-12.htm17 https://comptroller.nyc.gov/newsroom/comptroller-stringer-and-major-pension-funds-with-backing-from-independent-proxy-advisors-vote-no-

campaign-at-epipen-maker-mylan-gains-momentum/18 https://comptroller.nyc.gov/newsroom/comptroller-stringer-nyc-funds-after-three-years-of-advocacy-proxy-access-now-close-to-a-market-

standard/19 https://www.accaglobal.com/content/dam/acca/global/PDF-technical/financial-reporting/reassessing-value.pdf20 https://corpgov.law.harvard.edu/2018/05/23/congress-increases-pressure-on-proxy-advisory-firms/21 https://www.wsj.com/articles/cracking-the-proxy-racket-1537227532

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While this line of argument may seem commendable, it is not the type of decision that a fiduciary should make in regard to its fund. The primary goal of the CalPERS board, and every other fiduciary, is to ensure the strong and stable performance of its fund. Tobacco stocks were, and still are, high-performing investments. It is estimated that the annualized return on tobacco-related securities is around 18.6%, compared to a broad market return of 7.4%. Further, a review of the CalPERS divestment concluded the act ended up costing the plan in excess of $3 billion.22 And though CalPERS staff encouraged the board to end its divestment strategy, in 2016 it voted to continue this politically motivated distortion of ESG investment.

This is a prime example of the principal-agent problem of ESG investing for public pensions. The individuals on the CalPERS board had desired outcomes other than just the strong financial performance of the CalPERS fund. While surely the board members were concerned about achieving a high rate of return, they were also concerned about appearing as a “responsible” government entity by taking measures to improve public health. Thus, on a political level, it made more sense for them to divest from tobacco stocks, as they would benefit more from the political rewards of divestment than from the strong performance of their fund. ESG investing has the potential to exacerbate the principal-agent problem in public pensions as fund managers begin to have incentives to use their power to achieve their personal political goals.

Case Study – New JerseyThe New Jersey State Investment Council is currently developing a formal ESG policy to guide the investment of state funds, including its over $75 billion in pension investments. Even though the process is not yet complete, this has not stopped the fund’s managers from incorporating social and environmental issues into their investment strategy. New Jersey has made this decision even though it could mean a loss of $300 million a year in returns.23

Although many states are struggling with their pension systems, New Jersey is among the worst. Of the seven state pension plans, only two of them (the smallest two) are fully funded. Combined, the plans’ unfunded liabilities total over $40 billion with a funded ratio of just around 55%.24 Clearly the state is not in a strong enough position to be taking risks with its investments. Further, the Director of the Division of Investment Chris McDonough recently revealed that the state has yet to predict the potential impact ESG investment will have on investment returns. This revelation is problematic because it suggests that the state is undergoing its ESG strategy without a clear understanding of the possible implications.25

New Jersey’s story is emblematic of the larger problem of a lack of data on ESG investing in public pensions and the possible dangers of going in blind. New Jersey appears to be getting ahead of itself when it comes to ESG, making investment decisions before developing a formal policy or forecasting a realistic effect on returns. The state is still in the process of looking for a corporate governance officer to oversee the state’s expansion of ESG.26 Experimenting with pension funds before the data is out is irresponsible as the funds represent the financial security of New Jersey’s former teachers, police officers, and thousands of other public servants.

22 https://www.calpers.ca.gov/docs/board-agendas/201612/invest/item05b-00.pdf23 https://www.northjersey.com/story/news/new-jersey/2018/07/09/new-jersey-pension-investments-guided-social-environmental-

values/680349002/24 https://www.state.nj.us/treasury/pensions/documents/financial/gasb/statutory-summary-chart-2017.pdf25 Ibid.26 http://www.pionline.com/article/20180719/ONLINE/180719836/nj-looking-to-hire-corporate-governance-officer-for-esg

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Case Study – IllinoisIn recent years, there has been a growing movement that calls on organizations to divest from the state of Israel. This movement has had some success in convincing various universities and financial institutions to withdraw their financial support from Israel over various issues. In reaction to this movement, another divestment movement has arisen that calls for divestment from institutions that engaged in Israeli divestment.

An example of such divestment occurred in the state of Illinois in 2015. That year Illinois passed a bill requiring the state’s pension systems to divest from companies who engage in boycotts of Israel.27 This law made Illinois the first state to take such action over the incredibly complicated issue. At its time of passage, many critics said that the law was politicizing the state’s pension funds and setting dangerous precedent that would allow for future acts of divestment based off a political ideology.

There is perhaps no issue more complicated and divisive than the situation between Israel and Palestine. A 2014 study by the Brookings Institution showed the American public is deeply divided over many of the issues surrounding the Israeli-Palestinian conflict.28 Thus, it is all but certain there are members of the Illinois pension systems who lie on both sides of this issue and do not want their funds being used to make this political statement. These states would be better off focusing on achieving a high rate of return (as per their fiduciary responsibility) rather than using funds for a political agenda.

CONCLUSIONESG investment is an important tool for diversifying portfolios and impacting corporate governance. But at the end of the day, public pension fiduciaries need to focus on the financial returns of their investments. Considering that public pensions in the U.S. have unfunded liabilities of at least $4 trillion, the emphasis on ensuring strong returns is more important than ever.29 While ESG investing can have benefits when considered as a part of a robust investment strategy, ultimately, if the investment does not add alpha then the fiduciary should opt for something else.

27 http://www.ilga.gov/legislation/BillStatus.asp?DocNum=1761&GAID=13&DocTypeID=SB&SessionID=88&GA=9928 https://www.brookings.edu/research/american-public-attitudes-toward-the-israeli-palestinian-conflict/29 https://www.wsj.com/articles/the-pension-hole-for-u-s-cities-and-states-is-the-size-of-japans-economy-1532972501?ns=prod/accounts-wsj‌

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